Strategies for maximizing tax-advantaged outcomes

Strategies for maximizing tax-advantaged outcomes

Vanguard Perspective

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November 22, 2022

When markets are volatile, it's helpful to refocus your clients on things they can control. How money is invested, and when and how income is generated are both areas you can control for your clients. Wise decision-making in these areas may reduce their tax bill.

Take advantage of the array of tax- advantaged accounts

Using a tax-deferred retirement account is a good idea. Using two or three may be better. An up-front tax deferral through contributions to a traditional IRA or employer-sponsored retirement plan might be most beneficial in some years, but contributions to a Roth IRA may be even more beneficial as growth to a Roth IRA is tax-free. Roth IRA contributions are made after-tax, so there's no deduction. Other tax-advantaged accounts include HSAs, 529 plans, and annuities.

Use multiple Roth strategies

Roth IRAs offer tax-free investment growth and income, but contribution limits may apply to high earners. High earners cannot take advantage of Roth accounts directly unless they have a Roth 401(k) through their employer. However, conversions may provide an option around the Roth IRA income cap. High earners can consider nondeductible contributions to a traditional IRA and may retain the ability to convert those funds to a Roth later.

Understand the benefits of health savings accounts (HSAs)

If clients have a high-deductible health plan (HDHP), consider an HSA. HSAs provide unique tax benefits: Contributions are tax-deductible, investment growth is tax-deferred, and no taxes or penalties apply if the funds are used on doctor's visits, medications, or other qualified medical expenses. Other accounts don't offer this three-pronged tax break but it's also important to make sure clients know their contribution limits and the trade-offs of a high-deductible health plan. Additionally, spouse and non-spouse beneficiaries receive much different tax treatment when inheriting an HSA. Spouses can treat inherited HSAs as their own; for non-spouses, the account becomes immediately taxable at death.

Options for withdrawing unexpectedly from retirement savings

Tapping into retirement savings may not be ideal. But it's good to know that with various tax-advantaged accounts, there's potential flexibility for early withdrawals. For example, clients can withdraw Roth IRA funds without tax consequences up to the contribution amount.

While 401(k) plans often offer the option to take a loan or hardship withdrawal, traditional IRA accounts have exceptions for penalty-free withdrawals as well, such as home buying ($10,000 lifetime limit) or qualified education expenses.

Let your client's needs guide your recommendations

While there's no single order of priority for these accounts that works for everyone, a client's individual circumstances can help guide you. Here are some general guidelines to consider:

  • During accumulation, tax deferral is equally effective across account types, however, not everyone qualifies for all account types.
  • Know the rules around availability, qualification, tax-treatment, and transfer options at death.
  • Consider short- and long-term liquidity needs of your client.
    • Long term: Employer sponsored plans, other tax-deferred accounts (traditional and Roth IRAs, HSAs, etc.)
    • Short term: Taxable accounts and Roth IRAs offer more liquidity.

Advising clients on which tax-deferred and tax-free accounts to use, and when, is an important way that advisors can create value for their clients. Equally important is knowing how to allocate your client's money across these account types to meet both short-term and long-term financial goals.

Make asset-location decisions with taxation in mind

A diverse asset-allocation plan is essential for smart investing, but certain asset classes are better suited to tax-deferred accounts and others to taxable accounts. Portfolio construction should consider the tax ramifications of various asset classes with the tax treatment of account types. The primary drivers of asset location decisions should include: applicable tax rates, whether the holding is actively or passively managed, any wealth-transfer indications, and the implementation of ongoing rebalancing strategies.

Guidelines for which assets to place in tax-deferred accounts:

  1. First, holding bonds and investments that generate interest or ordinary income.
  2. Second, locate actively managed equity in tax-deferred accounts to avoid taxes on annual distributions.
  3. Finally, only once fixed instruments and actively managed equity are all held in tax-deferred accounts do you allocate the remaining shelf space to passive equity holdings.

While these are solid guidelines, it's important to consider all aspects of an individual's financial plan in personalizing their asset-location strategy. For example, an individual with a specific wealth-transfer bequest may benefit from holding those shares outside of a tax-deferred account to receive a step up in basis.

 

Consider a framework for account drawdowns

Chart

Note: Withdrawal-order preferences may vary based on personal situations and goals.

Drawing down accounts in retirement should be an orderly process. In generating income, first rely on distributions that cannot be avoided like required minimum distributions (RMDs) from traditional 401(k) or IRA accounts. Additionally, annual dividends and capital gain distributions from active holdings in taxable accounts cannot be avoided and are a solid second source of income. Additional withdrawals from taxable accounts and non-RMD withdrawals from tax-advantaged accounts should generally come last since these are the most burdensome for taxation. For additional income, it is best to consider the client's current and future tax situation to determine whether it makes the most sense to take additional distributions from tax-deferred accounts, triggering ordinary income, or sell taxable securities, triggering capital gains.

Taxes are complicated, and it's easy for clients to make mistakes without guidance. When compounding capital for retirement, a tax-planning error could be costly. Have a plan for clients to maximize the benefits of tax-advantaged accounts to secure a better financial future.

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New tax optimization series: Explore ways to optimize your after-tax returns in retirement

Share this end-investor version with your clients to help them better use tax-advantaged accounts.

Notes:

  • For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
  • All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).
  • Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal adviser about your individual situation.

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